All states require by statute that workers' compensation insurance carriers maintain reserves to fund anticipated future losses to be incurred from workers' compensation claims. In California, for example, workers' compensation rules are set forth in Cal. Ins. Code .sctn.923.5, .sctn.11550, et seq. (West 1988) and Cal. Labor Code .sctn.1100, et seq., .sctn.3200, et seq. (West 1989). As a general matter, this area of the law is highly regulated by the government.
Because of the statutory requirements, and also because of purely economic reasons, such as maintaining solvency, it is desirable for workers' compensation insurance carriers to be able to maintain a loss reserve amount which corresponds as closely as possible to the actual ultimate liability from workers' compensation claims. Due to the inherent uncertainty in predicting or forecasting such prospective liabilities, reserve amounts maintained by carriers are very likely to substantially exceed or substantially underestimate the actual ultimate costs incurred on such workers' compensation claims. Such disparities between predicted losses and actual losses annually cost workers' compensation insurance carriers, overall, millions of dollars. For example, California's Insurance Rating Bureau has published statistics to the effect that California insurance carriers have been underreserving at an overall rate of 15% on maintained loss reserves over the period from 1985 to 1989. Computed on $677 million in policy holders' dividends paid out by California carriers in 1989, a 15% error rate for reserves equates to an approximately $101 million error. Also, underreserving results in artificially high dividend payments to employers, potential insolvency of the insurance carrier itself due to insufficient reserves to pay current obligations, a showing of artificially high company profits because of the failure to show true losses, and inaccurate computation of insurance premiums. Overestimation of loss reserves can cost an employer dividend dollars and will overinflate the employer's experience modification resulting in an artificial increase in premiums charged in subsequent years.
Difficulties in accurate future loss prediction may be the consequence of one or more of a number of factors. For example, manual methods have relied on the experience and judgment of individual claims adjustors or supervisors. The varied capabilities, performance and decision making powers of such individuals, as well as their inability to properly synthesize and analyze large quantities of available historical data and information, may result in inaccurate predictions. Also, periodic review of aggregate loss reserves by actuaries has proved to be an inadequate method of accurately forecasting workers' compensation liabilities.
Because of changing workers' compensation state benefit legislation, it has become increasingly important to accurately set loss reserves on a per-claim basis since state benefits apply on an individual claim basis rather than aggregately. Further, loss reserves have come under more thorough scrutiny by employers, brokers, rating bureaus, regulatory agencies, consultants, and consumer groups. Because existing methods for setting loss reserves are often inaccurate, and thus inadequate, it has become increasingly difficult, expensive and time-consuming for insurance carriers to defend their loss reserves to these organizations.
For the foregoing reasons, it is desirable to have a standardized method for determining loss reserves which would allow both insurers and employers to budget and forecast more accurately and thus to reduce losses and improve the overall financial solvency of the insurance carrier.